Goldman’s unwanted super-senior position

By Felix Salmon

April 21, 2010

Kate Kelly has the obvious answer to the question of what on earth Goldman Sachs was doing with that 45-50% super-senior tranche:
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“The core of the SEC’s case is the allegation that one employee misled two professional investors by failing to disclose the role of another market participant in a transaction,” said Goldman CEO Lloyd Blankfein said in a recent message to employees. The firm “assumed risk in the deal, and we lost money,” he added.

But Goldman invested the money only because sales of the deal didn’t play out as planned, forcing Goldman to step up with its own money, people familiar with the matter say.

This is surely exactly right. We’ve already seen that it took Goldman a full five weeks after the deal closed just to wrap the 45% of the super-senior tranche that it did manage to get off its books — and it did so at the end of May 2007, when the mortgage market was hitting three-month highs and there was a lot of hope in the market that the early-2007 crash in the ABX index had been a short-lived aberration.

Here’s my theory of what happened: Goldman intended to wrap the super-senior tranche with ACA more or less at exactly the same time as the deal closed. But it couldn’t come to terms with ACA on the question of posting collateral: ACA, which only had a single-A rating even then, wanted a Berkshire Hathaway-style deal whereby it didn’t need to post collateral on a day-to-day basis and just needed to pay out once there was a credit event. That wasn’t acceptable to Goldman’s risk managers, which spent a good amount of time putting a deal together whereby ABN Amro would buy the wrap from ACA, and in turn would sell insurance to Goldman while posting collateral as necessary.

But the price rose when Goldman had to go through ABN Amro, and so Goldman ended up offloading only the top 45% of the 50% super-senior tranche. The rest it kept on its own books as a trading position, looking to sell that unwanted long position on an opportunistic basis.

And then Goldman ran out of time: before it could sell the position, the structure had started imploding, and Goldman was stuck with $90+ million of losses.

Which now Blankfein and Goldman are trying to turn into some kind of virtue.

This is one of those things a bit like the argument saying that ACA rejected half of Paulson’s picks: making the argument involves making a subtle implication that the case would be stronger were these facts not true. Is Goldman saying that the SEC’s case would be stronger if ACA had not rejected any of Paulson’s picks? Is it saying that the SEC’s case would be stronger if Goldman had managed to wrap the whole super-senior tranche and had ended up making a profit on the deal? Because it’s pretty obvious that Goldman would have been perfectly happy with the outcome in both those cases, and still wouldn’t have disclosed anything more than it did.

Of course, you can’t sue a bank for not disclosing information in a hypothetical deal which never actually happened. But the legal case is only half the point, and not even the more important half. The ethical case is what matters, and Goldman’s doing a very bad job of answering that one.